To everything, there is a season. Seasons change. For quite a while now, the general level of implied volatility (IV) has been very low. But with last week’s sharp sell-off, IV ticked upward.

The strategies we use when IV is just low-ish are different from the ones we use when IV is very low. I wrote earlier about Straddles and Strangles, and also Backspreads. These work well with very low IV if we have a neutral price bias. Simply buying calls or puts also works well with very low IV, if we’re bearish or bullish, respectively (if we’re right).

Follow up:

But the lift we expect from an increase in IV with those strategies, is less certain when IV is not at an extremely low level. That’s where we are as of this writing. The IV of the S&P has increased from about 11% to about 15%. Over the last year, it’s ranged from 11% to 25%. So it’s time to pack up those strategies, and break out a new set. What works in this environment are vertical spreads and horizontal (also called calendar) spreads. I’ve written about verticals for the last couple of weeks, so let’s talk about calendars.

Calendars come in three flavors: bullish, bearish, and neutral. Bullish calendars are done with calls; bearish ones are done with puts; and neutral ones can be done with either. In any of the three cases, we buy one option at an expiration date that is pretty far in the future, and simultaneously sell an option of the same type and strike price, but with a closer expiration date. The idea is to benefit from the difference in the rate of time decay. The nearby option (which we are short) decays away quickly, while the distant option (which we own) decays very slowly.

Here’s an example.

As of this writing (February 21), the SPY closed at $150.42, after dropping by about 2% in two days. It was sitting on a demand zone that extended from roughly $149.50 to $150.00. The supply zone overhead was at roughly $154 – $155. If the current demand zone held, we could expect a bounce back up to that area within a few days to weeks. This could be a good case for a bullish calendar spread. Here’s a picture of what that might look like:

Click to enlarge

We could have bought a May $154 call for about $1.90, and sold an April 154 call for about $1.15. The net debit would be ($1.90 – $1.15) = $.75 per share, or $75 per contract. This amount would also be our maximum loss. The maximum loss would occur if a) we held the position until the April expiration, and b) SPY was below around $142 at that time. We would plan not to let that happen. If SPY dropped below the bottom of our demand zone ($149.50), we would close the position. If this happened and IV stayed the same, this would result in a loss of somewhere between $17 and $38 per contract, depending on how quickly the drop occurred. The longer it took, the closer to the $38 figure it would be. The loss would occur because the price would cause our long (May) option to drop in value more than our short (April) option, since the long one has more time value to lose.

If the price did drop below our $149.50 stop price, and IV did not stay the same, but instead increased, our loss could be less. We might even have a profit. At our stop! This is because rising IV could push upward on the price of our long May call enough to more than offset the drop due to the underlying price decline. This is part of the beauty of the bullish calendar in this situation. If there is a price drop, it will quite likely be accompanied by an increase in IV, and that helps the position.

On the other hand, our best case would be where SPY bounced back to our $154 target, just at the April expiration date, and IV was constant or higher. In that case, the short April call would expire worthless, so we would keep the $1.15 we had received for it. The May call that we still owned would be at the money at that time, with a month left to go. Assuming IV remained constant, that May $154 call would then be worth about $1.58. (This number is an estimate that requires option analysis software to make. The Tradestation platform and others allow this modeling.) We would then sell that call and be better off by (profit on short call – loss on long call) = ($1.15 – ($1.90 – $1.58)) = ($1.15 – $.32) = $.83. So we’re risking about $33 to make up to about $83 – not bad.

Note that I keep saying “about” and “roughly.” This is because the situation at the April expiration is not cut and dried. The April call will have expired, but the May call will not. We’ll have to sell the May call to realize our profit; what it’s worth then will depend on both the price of SPY and its IV at that time.

Also note from the payoff graph that if the price of SPY is higher than the $154 strike, our profit doesn’t just level off. It begins to drop. So we’ll also plan to exit the position right away if SPY does reach our $154 target. What our profit is then depends on how long it takes. If that happens earlier than the April expiration, we will have less than our maximum profit. The short April call will not have decayed completely away, and having to buy it back will eat into our profits. “Worst” case to the upside would be if SPY hit our $154 target today. In that case, we’d just about break even. At the April expiration, our break-even range (assuming unchanged IV) would be from about 151.25 to $157 – if SPY were anywhere in that range at April expiration, we would make some profit. If IV were higher than it is now, we’d make more.

To summarize, with the bullish calendar spread we have:

A positive directional bias. We make money from an increase in price (positive Delta).

Initially a long time value position, which would benefit from increasing IV (positive Vega).

A position that profits from time decay (positive Theta).

When we are bullish and want some, but not too much, exposure to an increase in IV, a bull calendar spread can be just the ticket.

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